CHAPTER 14. Differential analysis, profitability analysis and capital budgeting CONTENTS
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1 CHAPTER 14 Differential analysis, profitability analysis and capital budgeting CONTENTS 14.1 Special order with opportunity costs 14.2 Make or buy decision 14.3 Profitability analysis 14.4 Alternative capital budgeting methods 14.5 Capital expenditure decision
2 14.1 ADDITIONAL PROBLEMS Problem 14.1 Special order with opportunity costs Burn-True Ltd manufactures gas barbecues and is considering expanding production. A distributor has asked the company to produce a special order of 2500 barbecues to be sold in another state. The barbecues would be sold under a different brand name and would not influence Burn-True Ltd s current sales. The plant is currently producing units per year. The company s maximum capacity is units per year, so the company would have to reduce the production of units sold under its own brand name by 500 units if the special order is accepted. The company s statement of financial performance for the previous financial year ended 30 June 2003 is summarised below: Sales ( units) Cost of goods sold: Direct materials Direct labour Factory overhead GROSS PROFIT Selling expenses Administrative expenses BURN-TRUE LTD Statement of Financial Performance for the year ended 30 June 2003 $ $ NET PROFIT $ The company s variable factory overhead is $20 per unit, and the variable selling expenses are $10 per unit. The administrative expenses are completely fixed and would increase by $ if the special order is accepted. There would be no variable selling expenses associated with the special order, and variable factory overhead per unit would remain constant. The company s direct labour cost per unit for the special order would increase 5%, and direct materials cost per unit for the special order would increase 10%. Fixed factory overhead and fixed selling expenses would not change. If the distributor has offered to pay $264 per unit for the special order, should the company accept the offer? Show calculations to support your conclusion.
3 14.2 BURN-TRUE LTD CM special order: Selling price $264 Variable costs: Direct materials $110 Direct labour 84 Variable overhead CM per unit $50 Units Total CM special order $ Less: Increase admin expense $ Less: Opportunity cost CM foregone 500 ($ ) Increase in profit if the order is accepted $ The order should be accepted.
4 14.3 Problem 14.2 Make or buy decision Eazy Watch Pty Ltd manufactures television receivers and is considering ways to utilise what is currently unused plant capacity because it has recently been operating at slightly below 70% of capacity. One proposal is to produce a component used in several of the company s products that is currently being purchased from a supplier for $70 per unit. The company uses components each year. Based on a study by the company s accounting department, the estimated cost of producing each component is as follows: Direct materials $24.00 Direct labour (3 $11.20 per hour) Factory overhead Total $ Factory overhead is applied to all products on the basis of direct labour hours. The expected capacity for the year is 2 direct labour hours. Fixed factory overhead for the year is budgeted at $ A. Should the company continue to purchase the component or produce it internally? What is the cost differential involved? B. The company s sales manager has recommended that a new product should be introduced instead of considering the production of the components. He estimates that the unused plant capacity could be utilised to produce units of the new product, each of which would have an estimated contribution margin of $12. One new machine at a price of $ would be required to produce the new product. The machine has a useful life of units. Would this alternative affect your decision in requirement A? Why? EAZY WATCH PTY LTD A. Relevant costs to manufacture: Direct materials $24.00 Direct labour Variable overhead (1) 6.00 $63.60 Cost to purchase Differential in favour of manufacture $6.40 The company should manufacture the component for a total cost saving of ( $6.40) $ (1) Overhead allocation rate is $24/3 = $8 per DLH Total estimated overhead $8 2 = $ Budgeted fixed overhead Budgeted variable overhead $ Variable overhead per direct labour hour ($ /2) = $2 per direct labour hour. B. Annual CM new product $12 = $ Annual cost of machine ($ /5) Cost savings to manufacture component Net advantage of component production $8 000
5 14.4 Problem 14.3 Profitability analysis Fly-Quick Parcel Co. Ltd operates an overnight package delivery service and is planning the next year s operation. The company s operating assets are estimated to be $ at the beginning of the financial year and $ on 30 June end of financial year. The company anticipates that it will deliver packages during the year. The variable costs per package average $5, and total fixed costs are budgeted at $ A. What price should the company charge to deliver a package to earn a 20% beforetax return on the estimated investment in operating assets? B. Calculate the approximate profit margin earned and turnover of assets expected for the company s next financial year. The company will not have any interest expense. Use the price from requirement A. C. If the company can reduce the variable costs needed to deliver a package by $1.15, what would be the effect on the return on the estimated investment in operating assets? D. If the company actually delivers packages at the price determined in requirement A, what is the company s rate of return on its budgeted average investment in operating assets? E. Refer to requirement A. If the company requires a return on investment of 15%, how much residual profit can be expected for the next financial year? A. B. FLY-QUICK PARCEL CO LTD Average investment ($ $ )/2 = $ Let X = Delivery charge X = 5(40 000) () X = X = $18.60 Profit margin ( $18.60 $5) ($18.60) = = = 25% (rounded) C. D. E. $ Asset turnover = 0.81 ROI (B) $ = 20% ROI (C) ($ ) = 25% An increase of 5% ($18.60 $5) ROI = 17% Operating profit (B) $ Minimum acceptable return (1) Residual profit $ (1) 0.15 ()
6 14.5 Problem 14.4 Alternative capital budgeting methods Lam and Kim Processing Ltd is considering three investments for the new year. The company has a cost of capital of 16%. Summary information concerning the net cash inflows of the investments and their initial costs is shown below: Investment Year A B C $ $ $ Initial cost $( ) $( ) $( ) A. Calculate the payback period for each investment. B. What is the net present value for each investment? C. What is the net present value index for each investment? D. Should any of these investments be accepted? If so, in what order should they be accepted, given limited available funds? LAM AND KIM PROCESSING LTD A. Payback period: Project: A B C $ $ = years $ $ = years $ $ = years B. NPV Project: A: ($70 000) $ = $0 B: ($) $ = $ C: ($) $ = ($29 919) C. Present Value Index Project: A: $ /$ = 1 B: $ /$ = C: $ /$ = D. Project B should be accepted. Projects A and C are not acceptable.
7 14.6 Problem 14.5 Capital expenditure decision Power Electronics Ltd is an engineering consulting company specialising in the installation of highly sophisticated electronic communications systems. The company is considering the purchase of testing equipment that would be used on jobs. The equipment would cost $ and would have no residual value at the end of its 5-year life. Straight-line depreciation would be used if the equipment is purchased. The company s accountant projects revenue and expenses with the operation of the equipment that are equal to the cash inflows and cash outflows associated with it, except for depreciation. A summary of the cash flows expected from the equipment (without considering taxes) is as follows: Year Revenues $ Expenses (excluding depreciation) $ Assume the company s expected tax rate is 30%, and its cost of capital is 12%. A. Calculate the return on average investment for the equipment. B. Determine the annual net cash inflows (after tax) expected from the operation of the equipment. C. Calculate the net present value for the investment. D. Determine the net present value index for the investment. E. Should the testing equipment be purchased?
8 14.7 POWER ELECTRONICS LTD A. Year Net cash Net profit Tax Net profit inflow before Depreciation before 30% after tax depreciation 1 $ $ $ $2 322 $ Total net profit after tax Average net profit after tax $ Return on average investment Average net profit after tax Average investment = 24% B. Year Net profit After back Net cash inflows After tax depreciation after tax 1 $ $ $ C. Year Expected net PVPV cash inflows 12% cash flows (rounded) 1 $ $ Present value cash flows Initial investment Net present value $ D. Net present value index $ = $ $ /2 E. Yes. NPV is positive. Net present value index greater than one. =
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